A Warning to Clean Energy Companies Eyeing China's Markets

Circular 698 caused a momentary pause throughout the business anglo-sino-blogosphere late last year.

China passed a retroactive look-through provision that effectively changed the rules for foreign investment structures in China. The Circular in and of itself is relatively innocuous. It highlights an oft misunderstood Chinese business sensitivity in China’s central economic planning: China for Chinese business only.

As China carries forward its strategy to adapt to and mitigate climate change, foreign owned clean technology businesses need to be aware of China’s position.

Circular 698 makes certain that all businesses doing business in China pay tax to the government; or restated: A portion of all revenue earned on the backs of Chinese citizens benefits Chinese citizens. According to Patrick Chovanec, a lecturer in economics and management at Tsinghua University in Beijing,

“This is both similar and dissimilar from what other countries do to the degree that this is sort of like a look-through provision: If you structured off shore purely for tax benefits, we will treat it as though it’s an onshore structure.”

Structuring private equity arrangements was convenient for Chinese citizens because it allowed them to avoid paying tax. But China’s State Administration of Foreign Exchange (SAFE) closed off this loophole, issuing a circular that stated that any Chinese citizens wanting to set up offshore companies needed state approval.

But, Chovanec says, these laws are “very typical Chinese regulation in the sense that it’s extremely vague and it’s vague on purpose because whenever China issues a regulation they tend to make it very broad so that they have maximum room for interpretation as time goes on.”

What is unique about this circular is that it “appears,” according to Chovanec, that “this is written in a way that seems to apply also to non-residents who use a holding structure to invest in China, and that’s very unusual.” In other words, any foreign nationals investing in China through an offshore structure will now be subject to Chinese capital gains taxes.

Many foreign investors set up offshore structures to invest in China. Not for tax reasons, explains Chovanec, but so “that you didn’t need regulatory approval from China to list the company and do whatever you wanted to do, reorganize it however you wanted to reorganize it. Also, you were not under Chinese corporate law, so you could set it up in a jurisdiction that allowed many more things like options, clawbacks, more typical things you would see in a private equity arrangement that Chinese corporate law doesn’t really allow for.”

International lawyer Steve Dickinson at Harris Moure places the regulatory laxity in context:

“For a brief period from 1998 to 2005, China just let this go because they were desperate for development. Starting in 2006, they started to reign things in. … In summary, China wants no unauthorized offshore market for Chinese business assets.”

Like the Google search censoring controversy, Circular 698 is a reining-in of foreign elements in China’s personal growth, a maintenance of China’s dominance in its own affairs.

Both the Internet and the energy market, key facets of China’s relationship with the U.S., are factors of the Chinese psyche. The Internet can be thought of as a means of expression and therefore plays a role in cultural identity. In the same sense, the domestic Chinese market is integral to national identity in its ability to provide for the Chinese people.